Coyne: Soak the rich! Abolish the corporate income tax

Why do we tax corporations? No, seriously — why? If you’re like most people and all New Democrats, your response will be “because that’s where the money is,” or some variant thereon. Corporations have lots of money, the thinking runs, and are unlikely to mind if the government helps itself to some of it. And since they don’t vote, it doesn’t much matter if they do mind.

An economist, on the other hand, would point out that, one way or another, all of the income earned by a corporation finds its way back to the people who financed it, whether in the form of interest on debt or dividends on shares or, in the event the corporation opts to hold onto the cash, in an appreciating share price.

In which case, why not simply tax those individuals directly? Especially since, notwithstanding the name, it’s not the corporation that pays the corporate tax. Just as all of a corporation’s income ultimately accrues to its investors — the “corporation” merely describes the legal relationship among them — so, in the end, all taxes are paid by people.

Ah, but which people? It might be thought from the foregoing that it’s those same investors. Indeed, that’s why Canadian tax law provides individuals a tax credit on the dividends they received, while taxing only one-half their capital gains: in recognition of the tax that has already been levied on the same income at the corporate level. (Since corporations can deduct their interest expenses from income, bondholders are entitled to no such offset.)

But in fact the evidence suggests that shareholders do not bear the bulk of the tax. Capital is highly mobile these days, and shareholders are unlikely to tolerate after-tax returns that are less than they can obtain elsewhere. Margins being what they are, that means firms have little room to pass the tax on to shareholders. Ditto consumers, for much the same reason.

Who does that leave? Workers. As much as three-quarters of the tax, according to recent research, gets passed on in the form of lower wages for the company’s employees. So we have a system that gives shareholders a substantial break for taxes that, for the most part, they didn’t pay. Wouldn’t it be simpler, and fairer, just to tax shareholders directly? Among other benefits, that would allow taxing wealthier shareholders at a higher rate than poorer. Whereas the corporate tax treats them all the same.

If you want to soak the rich, in other words, abolish the corporate income tax — and with it the tax break on dividends and capital gains. That in a nutshell is what the economists Robin Boadway and Jean-Francois Tremblay have proposed in a recent paper* for the Toronto-based Mowat Centre. Not only would well-to-do shareholders pay more, but workers would see their paycheques rise.

They point out that the last good answer to the why-do-we-tax-corporations question — to prevent individuals from turning themselves into corporations as a way of deferring tax — is largely obsolete. With the proliferation of tax-free savings vehicles in recent decades — RRSPs, RESPs, TFSAs and so on — most people can already shelter all the extra income they want.

Indeed, combined with the GST and provincial sales taxes, it is arguably a misnomer to speak of Canada as having a personal income tax: It’s pretty much a consumption tax. That’s the system most economists recommend. Why? To ensure the tax system does not bias decisions against investment.

Savings represent future consumption — that’s why you save a dollar today, to be able to consume a little more than a dollar tomorrow. Taxing savings, as under a pure income tax system, effectively amounts to taxing future consumption more heavily than present consumption (since both the initial dollar and the return on it are taxed). Whereas by taxing consumption you can ensure the tax burden is the same either way.

The question is why we have not done the same on the corporate side. Not only is the corporate income tax a strong disincentive to invest — a project that might pay a high enough return before tax to justify the investment no longer does so after tax — but it inevitably introduces other distortions into the system. That’s because much of what goes into “income” — depreciation, capital gains, inflation — involves comparing the values of things at different points in time. That’s hard to get right, and invites all sorts of fiddling about.

So what many economists recommend, in place of the corporate income tax, is a cash-flow tax: all cash in is taxable, all cash out is deductible. The tax falls on the difference. No complicated amortization or depreciation schedules: capital purchases are just expensed in the year they’re made. And whereas the present system is prejudiced in favour of debt finance — interest expenses are deductible, dividends are not — Boadway and Tremblay would allow a similar deduction for a “normal” return on equity. (After all, either way, it’s the cost of capital.)

Hence their version of the corporate tax would fall only on returns in excess of the normal rate (essentially the interest rate, adjusted for risk), or as economists call them, “rents.” These are the kinds of windfall profits companies are sometimes fortunate enough to earn — for example, when resource prices spike. That’s pure gravy: You can tax it without deterring investment, or scaring off those skittish shareholders. They’re not going to get a better deal anywhere else. Which means the tax is more likely to be passed onto them.

Whew. That’s a lot of economics. If it helps any, think of it in terms of the slogan I suggested earlier: Soak the rich! Abolish the corporate income tax!

A National Post original, Andrew Coyne's journalism career has also included positions with Maclean's, the Globe and Mail and the Southam newspaper chain. In addition, he has contributed to a wide range... read more of other publications including The New York Times, The Wall Street Journal, National Review, Time and Saturday Night. Coyne is also a long-time member of the CBC’s popular At Issue panel on The National.View author's profile